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In the FX market, you buy or sell currencies. Placing a trade in the foreign exchange market is simple: the mechanics of a trade are very similar to those found in other markets (like the stock market), so if you have any experience in trading, you should be able to pick it up pretty quickly.
The object of Forex trading is to exchange one currency for another in the expectation that the price will change, so that the currency you bought will increase in value compared to the one you sold.
Example of making money by buying euros
Trader's Action EUR USD
You purchase 10,000 euros at the EUR/USD exchange rate of 1.18 +10,000 -11,800*
Two weeks later, you exchange your 10,000 euros back into US dollars at the exchange rate of 1.2500. -10,000 +12,500**
You earn a profit of $700. 0 +700
*EUR 10,000 x 1.18 = US $11,800
** EUR 10,000 x 1.25 = US $12,500
An exchange rate is simply the ratio of one currency valued against another currency. For example, the USD/CHF exchange rate indicates how many U.S. dollars can purchase one Swiss franc, or how many Swiss francs you need to buy one U.S. dollar.
How to Read an FX Quote
Currencies are always quoted in pairs, such as GBP/USD or USD/JPY. The reason they are quoted in pairs is because in every foreign exchange transaction you are simultaneously buying one currency and selling another. Here is an example of a foreign exchange rate for the British pound versus the U.S. dollar:
GBP/USD = 1.7500
The first listed currency to the left of the slash ("/") is known as the base currency (in this example, the British pound), while the second one on the right is called the counter or quote currency (in this example, the U.S. dollar).
When buying, the exchange rate tells you how much you have to pay in units of the quote currency to buy one unit of the base currency. In the example above, you have to pay 1.7500 U.S. dollar to buy 1 British pound.
When selling, the exchange rate tells you how many units of the quote currency you get for selling one unit of the base currency. In the example above, you will receive 1.7500 U.S. dollars when you sell 1 British pound.
The base currency is the “basis” for the buy or the sell. If you buy EUR/USD this simply means that you are buying the base currency and simultaneously selling the quote currency.
You would buy the pair if you believe the base currency will appreciate (go up) relative to the quote currency. You would sell the pair if you think the base currency will depreciate (go down) relative to the quote currency.
Long/Short
First, you should determine whether you want to buy or sell.
If you want to buy (which actually means buy the base currency and sell the quote currency), you want the base currency to rise in value and then you would sell it back at a higher price. In trader's talk, this is called "going long" or taking a "long position". Just remember: long = buy.
If you want to sell (which actually means sell the base currency and buy the quote currency), you want the base currency to fall in value and then you would buy it back at a lower price. This is called "going short" or taking a "short position". Short = sell.
Bid/Ask Spread
All Forex quotes include a two-way price, the bid and ask. The bid is always lower than the ask price.
The bid is the price in which the dealer is willing to buy the base currency in exchange for the quote currency. This means the bid is the price at which you (as the trader) will sell.
The ask is the price at which the dealer will sell the base currency in exchange for the quote currency. This means the ask is the price at which you will buy.
The difference between the bid and the ask price is popularly known as the spread.
Let's take a look at an example of a price quote taken from a trading platform:
On this GBP/USD quote, the bid price is 1.7445 and the ask price is 1.7449. Look at how this broker makes it so easy for you to trade away your money.
If you want to sell GBP, you click "Sell" and you will sell pounds at 1.7445. If you want to buy GBP, you click "Buy" and you will buy pounds at 1.7449.
In the following examples, we're going to use fundamental analysis to help us decide whether to buy or sell a specific currency pair. If you always fell asleep during your economics class or just flat out skipped economics class, don’t worry! We will cover fundamental analysis in a later lesson. For right now, try to pretend you know what’s going on…
EUR/USD
In this example Euro is the base currency and thus the “basis” for the buy/sell.
If you believe that the US economy will continue to weaken, which is bad for the US dollar, you would execute a BUY EUR/USD order. By doing so you have bought euros in the expectation that they will rise versus the US dollar.
If you believe that the US economy is strong and the euro will weaken against the US dollar you would execute a SELL EUR/USD order. By doing so you have sold Euros in the expectation that they will fall versus the US dollar.
USD/JPY
In this example the US dollar is the base currency and thus the “basis” for the buy/sell.
If you think that the Japanese government is going to weaken the Yen in order to help its export industry, you would execute a BUY USD/JPY order. By doing so you have bought U.S dollars in the expectation that they will rise versus the Japanese yen.
If you believe that Japanese investors are pulling money out of U.S. financial markets and converting all their U.S. dollars back to Yen, and this will hurt the US dollar, you would execute a SELL USD/JPY order. By doing so you have sold U.S dollars in the expectation that they will depreciate against the Japanese yen.
GBP/USD
In this example the GBP is the base currency and thus the “basis” for the buy/sell.
If you think the British economy will continue to do better than the United States in terms of economic growth, you would execute a BUY GBP/USD order. By doing so you have bought pounds in the expectation that they will rise versus the US dollar.
If you believe the British's economy is slowing while the United State's economy remains strong like bull, you would execute a SELL GBP/USD order. By doing so you have sold pounds in the expectation that they will depreciate against the US dollar.
USD/CHF
In this example the USD is the base currency and thus the “basis” for the buy/sell.
If you think the Swiss franc is overvalued, you would execute a BUY USD/CHF order. By doing so you have bought US dollars in the expectation that they will appreciate versus the Swiss Franc.
If you believe that the US housing market bubble burst will hurt future economic growth, which will weaken the dollar, you would execute a SELL USD/CHF order. By doing so you have sold US dollars in the expectation that they will depreciate against the Swiss franc.
I don't have enough money to buy 10,000 euros. Can I still trade?
You can with margin trading! Margin trading is simply the term used for trading with borrowed capital. This is how you're able to open $10,000 or $100,000 positions with as little as $50 or $1,000. You can conduct relatively large transactions, very quickly and cheaply, with a small amount of initial capital.
Margin trading in the foreign exchange market is quantified in “lots”. We will be discussing these in depth in our next lesson. For now, just think of the term "lot" as the minimum amount of currency you have to buy. When you go to the grocery store and want to buy an egg, you can't just buy a single egg; they come in dozens or "lots" of 12. In Forex, it would be just as foolish to buy or sell 1 euro, so they usually come in "lots" of 10,000 (Mini) or 100,000 (Standard) depending on the type of account you have.
For Example:
You believe that signals in the market are indicating that the British Pound will go up against the US dollar.
You open one lot (100,000), buying with the British pound at 1% margin and wait for the exchange rate to climb. When you buy one lot (100,000) of GBP/USD at a price of 1.5000, you are buying 100,000 pounds, which is worth US$150,000 (100,000 units of GBP * 1.50 (exchange rate with USD)). If the margin requirement was 1%, then US$1500 would be set aside in your account to open up the trade (US$150,000 * 1%). You now control 100,000 pounds with US$1500. Your predictions come true and you decide to sell.
You close the position at 1.5050. You earn 50 pips or about $500. (A pip is the smallest price movement available in a currency).
Your Actions GBP USD
You buy 100,000 pounds at the GBP/USD exchange rate of 1.5000 +100,000 -150,000
You blink for two seconds and the GBP/USD exchange rate rises to 1.5050 and you sell. -100,000 +150,500**
You have earned a profit of $500. 0 +500
When you decide to close a position, the deposit that you originally made is returned to you and a calculation of your profits or losses is done. This profit or loss is then credited to your account.
We will also be discussing margin more in-depth in the next lesson, but hopefully you're able to get a basic idea of how margin works.
Rollover
No, this is not the same as rollover minutes from your cell phone carrier! For positions open at your broker's "cut-off time" usually 5pm EST, there is a daily rollover interest rate that a trader either pays or earns, depending on your established margin and position in the market. If you do not want to earn or pay interest on your positions, simply make sure they are all closed before 5pm EST, the established end of the market day.
Since every currency trade involves borrowing one currency to buy another, interest rollover charges are part of forex trading. Interest is paid on the currency that is borrowed, and earned on the one that is bought. If a client is buying a currency with a higher interest rate than the one he/she is borrowing, the net differential will be positive (i.e. USD/JPY) - and the client will earn funds as a result. Ask your broker or dealer about specific details regarding rollover.
Also note that many retail brokers do adjust their rollover rates based on different factors (e.g., account leverage, interbank lending rates). Please check with your broker for more information on rollover rates and crediting/debiting procedures.
Don't know what the interest rates are for each currency? Here is a chart to help you out. Accurate as of 04/19/09.
Demo Trading
You can open a demo account for free with most Forex brokers. This account has the full capabilities of a "real" account. Why is it free? It's because the broker wants you to learn the ins and outs of their trading platform, and have a good time trading without risk, so you'll fall in love with them and deposit real money. The demo account allows you to learn about the Forex markets and test your trading skills with ZERO risk.
YOU SHOULD DEMO TRADE FOR AT LEAST 6 MONTHS BEFORE YOU EVEN THINK ABOUT PUTTING REAL MONEY ON THE LINE.
I REPEAT - YOU SHOULD DEMO TRADE FOR AT LEAST 6 MONTHS BEFORE YOU EVEN THINK ABOUT PUTTING REAL MONEY ON THE LINE.
"Don't Lose Your Money" Declaration
Place your hand on your heart and say...
"I will demo trade for at least 6 months before I trade with real money."
Now touch your head with your index finger and say...
"I am a smart and patient Forex trader!"
